Many companies invest in assets to support day-to-day operations and fuel growth. To pay for these assets, they can use debt, equity, or a combination of both. However, the balance of these sources of finance on a company’s books affect its overall health, so investors and creditors need a quick way to measure and compare it.
That’s where the equity multiplier ratio comes in.
In this article, we explore the equity multiplier and explain why it’s important.
What is the equity multiplier?
The equity multiplier is a financial leverage ratio showing how much of a company’s assets are funded by stockholder equity. To calculate the equity multiplier, you divide a company’s total assets by its total stockholder equity:
Equity Multiplier = Total Assets / Stockholder Equity
We run through a sample calculation later in this article.
A high equity multiplier implies that a company mostly uses debt financing to purchase assets, while a low equity multiplier suggests it relies more on equity. Either way, the multiplier is relative- it’s only high or low when compared with a benchmark such as the industry standards or a company’s competitors.
The equity multiplier is a key component in DuPont analysis, sometimes referred to as the DuPont model, a framework developed by the DuPont Corporation. DuPont analysis breaks down the different inputs into a company’s return on equity (ROE): net profit margin, asset turnover ratio, and equity multiplier. Investors and creditors use this analysis to assess which financial activities have the greatest influence on ROE. In terms of the equity multiplier, an increase boosts ROE and vice-versa.
The equity multiplier also helps to calculate a financial ratio known as the debt ratio which measures a company’s leverage. The debt ratio can be calculated two ways: by dividing the total debt by total assets or using the following formula:
1 - (1 / equity multiplier)
3 reasons why a business’ equity multiplier is important
Now that we’ve explained the basics of the equity multiplier, let’s look at some of the ways it’s used to assess a company’s health.
It reflects a company’s debt holdings
While the equity multiplier formula measures the ratio of total assets to total shareholder's equity, it also reflects a company’s debt holdings. This information can be found on a statement of owner's equity. As mentioned earlier, a company can only finance purchases of new assets using equity or debt. A low equity multiplier means it funds the majority of its purchases with equity, so it must have a relatively light debt burden. If a company has a high equity multiplier, it borrows to finance purchases, so its debt burden is higher.
It helps with investor or lender risk assessment
A company with a high amount of debt on its financial statements could be considered risky because it may struggle to meet its debt servicing costs, especially if cash flows slow down or net income decreases. If a company finds itself in this position, lenders may be unwilling to extend further credit. It may ultimately become insolvent.
It provides a useful metric of overall financial health for investors or creditors
A low equity multiplier is generally more favorable because it means a company has a lighter debt burden. That said, there are two caveats to bear in mind. A low multiplier may suggest a company is struggling to secure funding from a lender on reasonable terms. Conversely, a high multiplier could be justifiable if a company generates a greater rate of return on its debt than the interest rate charged by the lender.
What is the equity multiplier formula
The equity multiplier formula consists of total assets and total stockholder equity. Total assets refer to a company’s total liabilities plus its stockholder equity. Stockholder equity represents the amount of money invested in the business by the owners and any retained earnings. It can also be represented by a company’s assets less its liabilities. You can find both of these figures on your balance sheet.
To calculate the multiplier, you divide a company’s total assets by its total stockholder equity. In simple terms, if a company has total assets of $20 million and stockholder equity of $4 million, it has a multiplier of five. This means that the company finances its asset purchases with 20% equity and 80% debt, indicating it’s highly leveraged.
Examples of using the equity multiplier
To put the equity multiplier into context, let’s apply it to two companies competing in the mobile device industry: Apple and Samsung.
In the financial year to the end of September 2021, Apple’s accounts show it had $351 billion of total assets and its total shareholder’s equity was $63 billion. That gives Apple a multiplier of 5.5.
Samsung had total assets of ₩426 trillion at the end of the 2021 financial year and stockholder equity of ₩296 trillion, giving it a multiplier of 1.4.
On the face of it, Samsung may appear less risky than Apple because of its lower multiplier. However, Apple’s higher multiplier could be interpreted differently. With interest rates at record lows since the 2008 financial crisis, Apple has taken the opportunity to access cheap funding on several occasions over the last few years. It can justify borrowing because its revenues grew by an average of just over 11% a year between 2018 and 2021, much higher than the interest rate charged by lenders.
Interpreting the equity multiplier
To sum up, there’s no such thing as a good equity multiplier. A low multiplier may imply a lower debt burden, but a higher multiplier could mean a company is leveraging debt effectively. The equity multiplier provides a useful benchmark for investors and lenders, but further analysis is required to verify each individual company’s circumstances.